Diapositiva 1 - Facoltà di Economia

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Diapositiva 1 - Facoltà di Economia Powered By Docstoc
					La crisi
1.1 La crisi finanziaria
 I fatti
 Dizionario della crisi: mercato immobiliare, mutui sub-prime,
   cartolarizzazione e leveraging
 Focus: asimmetria informativa e mercato del credito


1.2 La crisi economica
 Il petrolio e la crisi
 Il credit crunch
 Gli effetti sul mercato del lavoro


1.3 Il barometro della crisi
 Il Pil come misura del ciclo economico
 Altri indicatori della crisi
 Focus: come la crisi influenza le previsioni di vendita aziendali



                                                                      1
Le risposte della politica economica alla crisi

Politica fiscale
 Il dizionario della politica fiscale: spesa, entrate, deficit e
  debito
 Focus: l‟aritmetica di deficit e debiti pubblici
 Le politiche fiscali durante la crisi
 Focus: Il moltiplicatore della crisi


Politica monetaria
 Dizionario della politica monetaria: tassi di sconto, bilancio
  della Banca Centrale, credit easing, Taylor rule
 Risposte differenti alla crisi: Fed e Bce
 Focus: What next, inflazione o deflazione?




                                                                    2
L’Italia prima e durante la crisi
Prima della crisi: il Tanto Paga Pantalone
 Inflazione, debito e svalutazione

 La corsa verso l‟euro

 L‟economia italiana nell‟euro: verso il declino?




                                                     3
Gli scenari del futuro

   Globalizzazione
   Offshoring
   Focus: I Bric (Brasile, Russia, India, Cina)
    traineranno il mondo?

Le centomila punture di spillo
 Storie di successo prima e durante la crisi




                                                   4
              La crisi
     (Slides spesso in inglese
ma lettura obbligatoria in italiano)




                                       5
       Qualcosa non è cambiato da prima
         della crisi: la finanza privata




20-21 settembre 2010   Francesco Daveri - Master Publitalia   6
  L’origine della crisi: i mutui sub-prime. Un
  piccolo problema …
 Cos‟era un mutuo sub-prime?
 Prestito ipotecario a soggetti con alto rischio di insolvenza rispetto ad altri
       soggetti più affidabili (“prime borrowers”)
 Chi sono i “sub-primers” negli Stati Uniti?
 Ad esempio, i detentori dei famosi mutui NINJA (= No Income No Jobs (no)
      Assets). Per esempio: (1) disoccupato afroamericano dell‟Alabama
      oppure (2) donne single divorziate con figli a NY
 Perché le banche prestavano ai NINJA?
 I “sub-primers” ricevevano e rifinanziavano il mutuo dando in garanzia una
       casa con valore crescente nel tempo (fino a che il mercato immobiliare
       è andato su)
 Importanza crescente dei sub-prime solo dal 2006
 (1) Quota mutui sub-prime su totale mutui: dal 5% nel 2004 al 20% in 2006 –
      da 35 a 720 mld $ (2) Rifinanziamento dei mutui esistenti è il 60% dei
      nuovi mutui (3) Un sub-prime su 3 finanziava il 100% dell‟acquisto della
      casa


20-21 settembre 2010         Francesco Daveri - Master Publitalia                  7
.. Ingigantito da: (1) Cartolarizzazioni ..




Attraverso cartolarizzazione dei mutui, enorme moltiplicazione
     del credito. Mutui sub-prime “distribuiti” al resto del
     mercato con RMBS (Residential Mortgage-Backed
     Securities) e acquistati da società specializzate (SPV) che
     ne compravano tanti. Obiettivo: diversificare il rischio
Problema: SPV possedute da banche e altri istituti finanziari,
     che spesso cartolarizzavano i crediti da loro stesse
     originati. Risultato: niente diversificazione del rischio
Invece: rischio sulle spalle dei clienti delle banche e dei fondi
     pensione acquirenti di titoli derivati dai mutui originali
 20-21 settembre 2010   Francesco Daveri - Master Publitalia   8
 .. E da (2) Leva finanziaria
A sua volta, cartolarizzazione dei mutui  intermediazione
    finanziaria attraverso la leva finanziaria
Usa: per le banche, il rapporto era 1:10 cioè 10 unità di credito
    per ogni unità di capitale. Per banche di investimento e
    hedge funds: il rapporto era 1:27
Esempio
Lehman Brothers: asset trattati=680 mld$, capitale netto=25 mld.
    Con 2% di margine in oneri di raccolta e rendimento sugli
    impieghi, profitti a 13,6 mld, pari al 54% del capitale investito
AIG: assicurava debito emesso dalle varie Lehman emettendo
    CDS (Credit Default Swaps)
“Assicurazione” per 3200 mld con un capitale di 25 mld. Cioè
    assicurazione effettiva solo se fallimenti pari a 0,5%. Invece,
    il tasso di fallimenti è salito al 7%


 20-21 settembre 2010    Francesco Daveri - Master Publitalia      9
A che cosa serviva tutta la liquidità in giro
Le imprese (spesso indotte dal private equity) hanno usato la
    liquidità per LBOs, fusioni e acquisizioni, e IPOs. Spesso
    a debito. Anche in Italia.




Ampio uso della leva finanziaria incoraggiato dai fondi di
   private equity. Private Equity Monitor indica per l‟Italia
   una leva di 4-6 (rapporto debito netto/Ebitda) per i fondi
   di private equity nel 2005-07. Affari e Finanza, 11/05/09:
   “Fondi locusta schiacciano le imprese”
20-21 settembre 2010   Francesco Daveri - Master Publitalia   10
Poi il diluvio
Il business model basato su sub-prime,
     cartolarizzazione e leva finanziaria entra in crisi
     quando salgono i tassi (il “maestro” Alan
     Greenspan aumenta il Fed Funds rate da 1.5 a 5.2
     pp tra il 2004 e il 2006)
Crolla il mercato immobiliare
A catena, boom di insolvenze, fallimenti di istituzioni
     finanziarie Usa (più di 100 in tutto), crolla l‟attività
     economica in tutto il mondo e l‟interscambio
     mondiale
La crisi bancaria e finanziaria diventa economica




20-21 settembre 2010   Francesco Daveri - Master Publitalia   11
  Cosa è cambiato dopo la crisi per la finanza
  privata?
Miliardi di              HSBC       Bank of        JP Morgan Citi  Unicredit                  Goldman
dollari                  Holdings   America        Chase     group                            Sachs

31 dicembre               197.8      183.1              166.5                 146.6   110.7     85.5
2007

31 gennaio                 86.4       39.8               90.6                 54.9    21.7      33.0
2009

11 settembre              187.1      147.9              146.6                 18.9    60.7      83.3
2009

28 febbraio               191.3      144.1              165.6                 96.8    48.7      80.5
2010


La capitalizzazione di Borsa delle banche e delle banche di
investimento è spesso tornata quella di prima della crisi
  20-21 settembre 2010                 Francesco Daveri - Master Publitalia                        12
    The “What” and the “How”
of two years spent living on the verge
             of collapse




                                         13
The “What” of the crisis
Since August 2007 through the first quarter of 2009, financial
      markets and financial institutions all over the world hit by
      catastrophic developments
     Insolvency of sub-prime mortgage borrowers: 250 billon $
Initial loss from insolvencies hugely amplified over time
Write-offs: Banks have written off of their balance sheets
      losses for many billion $ (800 billion dollars as of
      February 2009). Total losses for all financial institutions
      may be 2.2 triillion dollars
Liquidity: virtually disappeared from all of the important
      financial markets since August 2007. Then it is gradually
      returning, but a credit crunch is looming
Stock markets: have plunged. Minus 40% in 2008, globally.
      Another 22% through early March 2009. Since then
      +53% through mid September 2009 (+19% in 2009).Yet
      this means that if it were 100 on Dec 31 2007, in mid 14
      September 2009 it was about 72
The “What” of the crisis
Policy response
    Central banks: provided support on the order of hundreds of billion $
        to support financial markets and prevent breakdown of
         individual institutions
     Governments: stepping in with public funds to support financial
      institutions on a gigantic scale, in the United States, Europe and Asia
In spite of policy response
     Some estimates speak of total GDP losses (missing growth and
      sheer decline) in the world economy of as much as 5 trillion $ in
      2007-09. It looks high.
     Roughly speaking, for the US economy only: starting from a GDP of
      14 trillion $ and calculating a cumulated loss of 4.5% in one year and
      half, this means about 1 trillion (14000 times 7%=980 billion)




                                                                         15
The “How” of the crisis
Boom-and-bust cycle of the high-tech industry in the US in the
     1990s, the high-tech bubble ended with the “Dotcom
     bust” (bankruptcy of hi-tech start-ups)
This, plus Sep 11th, persuaded then Fed Governor Alan
     Greenspan to aggressively cut federal funds rate, down
     from 6% in 2001 to some 1% in 2003 (see picture 1)
In turn, another bubble showed up in the housing market
Then Greenspan - still aggressively - pushed Fed funds rates
     up, from 1.5% in 2004 to 5,2% in 2006, to cool it down
Eventually, sudden collapse of the US housing market
      Rise of insolvency among all mortgage borrowers
      Mostly among “sub-prime” borrowers (= 14% of total mortgage
       borrowers in 2006)
      Insolvency rates of sub-primers: Up from 11.6% at end 2005 to
       17.3% at end 2007                                            16
Picture 1: the interest rate policy of the Federal
Reserve (in blue) and housing prices (in red)


      20.00                               LTCM dot-com              current
      18.00                               crisis crisis              crisis
      16.00
      14.00
      12.00
      10.00                                                      ... then
       8.00
                                                                prickling
                                                                     it
       6.00                                               feeding
       4.00                                                 the
                                                          bubble
       2.00
       0.00
           1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

                   Composite-10 Case Shiller housing index (Jan. 1887 = 5)
                   Federal Fund rate (shaded areas are NBER recessions)
                                                                              17
 Picture 2: home prices in the US economy
 First: up at unprecedented speed since 2000 …




Source: S&P, Case-Shiller Index                       18
House prices deflated by CPI (consumer price index)
… then steeply down at end 2006
(% changes, US$ base) ….




                                  19
.. And US sub-prime mortgage delinquency rates
and foreclosure rates suddenly up as a result




  Source: Thomson Datastream.


                                                 20
   Yet as a result of interest rate hikes, sub-prime defaults and the
   housing market bust …
   .. market liquidity literally vanished from August 2007 to the
   first months of 2009




Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill
Lynch, Thomson Datastream and Bank calculations.


(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity
measures, normalised on the period 1999–2004. The series shown is an exponentially weighted moving average. The indicator is more
reliable after 1997 as it is based on a greater number of underlying measures.                                                       21
And then the What of the crisis starts in
August 2007 as we have seen before ..

.. and then it precipitates fourteen months later, on
     September 15, 2008 when …




                                                        22
The “Why” of the crisis




                          23
The “why” of the crisis
Vocabulary

    Leverage, write-offs and credit crunch

    Real estate economics

    Sub-primes economics
      Sub-prime loans
      Securitization of “sub-prime” loans

    Parallel banking system



                                              24
  An example
The current problem with pre-crisis banking systems in the US
  and elsewhere can be described through the example of
  Bank A and its balance sheet
Bank A has
 100 in assets (mortgages, commercial loans, etc. plus cash)

   assets = things that have value and theoretically could be

     sold to raise cash
 90 in liabilities (deposit accounts, bonds issued, other
  financing)
   liabilities = promises to pay money to other people

 10 in capital (= assets minus liabilities)

   capital = the net amount of value that is "owned" by the

     common shareholders
                                                            25
Leverage

Bank A‟s leverage = assets / capital = 10 (=100/10)

Average leverage in the US banking system before the
   crisis
Standard banks                                9.8
Investment banks and “hedge funds”           27.1

Our Bank A is a good example of a standard US bank
Lehman Brothers was an investment bank (until September
  15, 2008)

                                                       26
Write-offs
Assume that Bank A‟s assets (100 in all) fall in two
  categories
 60 of "good" assets
       loans that are still worth what they were when they were made
        (no defaults and no increased probability of default)
   40 of "bad" assets
       loans with very high probability of not being repaid, or mortgage-
        backed securities where the underlying loans have a very high
        probability of not being repaid
At some point Bank A writes off a part of its bad assets,
   say for an amount of 5. It is thus left with 35 of bad
   assets
What “bad” means? For example, if bank A had to sell its
   35 of remaining bad assets right now it would cash much
   less than 35 (say 20)


                                                                         27
Credit crunch
Now, after the write-off, Bank A‟s balance sheet has 95 in
  assets, 90 in liabilities, and 5 in capital, so it is still solvent
  (K>0)
However, everyone thinks that those 35 in bad assets are
  really only worth 20, and is afraid that the bank may need
  to take another 15 write-down in the future
So no one wants to buy (or even sell) Bank A‟s stock and,
  more importantly, no one wants to lend it money, because
  a 15 write-down would make the bank insolvent
Bank A could go bankrupt, stockholders would get nothing,
  and creditors (lenders to the bank) would not get all their
  money back
To avoid that, given that no one wants to lend it money, the
  bank hoards cash and does not lend to people who would
  need the money to consume and invest. This is the “credit
  crunch”, how the financial crisis hits the real economy
                                                                   28
Real estate economics
“Maturity mismatch”
Residential housing & real estate – an important part of the
     economy‟s aggregate wealth, in many countries more important
     than net financial assets
        mean ratios of housing wealth to income of 4.89 and net
         financial wealth to income of 2.68 in 2002
        For the US, these ratios were 3.01 and 3.84, the only case
         other than Belgium where net financial wealth exceeds housing
         wealth. A likely consequence of the stock market boom since
         the early 1980s
    Another fact to keep in mind: houses and real estate are very
     long-lived assets – several decades, much longer than time
     durations for which most people plan their savings and
     investments
Here‟s the issue: the discrepancy between economic lifetimes of
     these assets and investment horizons of most investors raises
     the problem of “maturity mismatch”: WHO BEARS THE RISK?
                                                                    29
Real estate economics
Who bears the risk of maturity mismatch?

  Want to finance purchase of house with economic life of
     40 years
  Three possibilities
    Homeowner: keeps up with the mortgage for 10
     years and then either sells the house or refinance the
     mortgage. Risk rests on his shoulders
    Investor: Extends 40-year mortgage to homeowner.
     Risk of early liquidation
    Financial intermediary: homeowner receives funds to
     buy the house from an intermediary that obtains the
     money from savings with short maturity (say: 7
     months through 4 years)

                                                        30
Real estate economics
Today’s problems are NOT caused by maturity
mismatch as such
  Tend to identify today‟s problems with bad
       functioning of the housing market, hence with
       maturity mismatch
  Wrong point.
  Think of eliminating “maturity mismatch”? Back to a
       world where homeowners only get financing if
       they find investor with same time horizon (40 yrs).
  Much fewer people could afford buying a house
  It is not maturity mismatch that drove the housing
       market to function badly. It was a problem of
       asymmetric information
                                                        31
Sub-primes economics
What is “sub-prime lending”?
    Lending to individuals with high level of default risk with
     respect to “prime” borrowers
       Low income earners: e.g. Jobless Afro-American in
        Alabama
       Bad borrowers: imperfect credit history; e.g. divorced
        single-mother in NY
    Not a novelty as such
    Yet only in the last few years subprime lending became
     an important “game in town”
       2001-07: 3 trillions $ of mortgages originated each
        year
       Share of sub-primes went up from 7% in 2001 to
        20% in 2006
       At end 2007: total outstanding stock of subprimes
        was some 1.4 trillions $
                                                              32
 Sub-primes economics
 How sub-prime lending works
Sub-primes = adjustable-rate mortgages with “hybrid
     structure”, partly variable and partly fixed rates
Example: 30-year mortgage; may be of “2/28” type
    A fixed rate for the first 2 years, incorporating a premium
     (say: 6 ppts) over benchmark interest rate (LIBOR)
    then switch to variable rate for the residual 28 years. After
     switch, often much higher monthly payments
Why should an unemployed, with wife and dependent sons, be
     so short-sighted to enter a contract like this?
All depends on the appreciation of the US housing market
    “Sub-primers” allowed by intermediaries to refinance their
     mortgage before the switch against increased house
     value. So as to avoid (or, better: postpone) default
       Refinancing made 50-70% of new yearly mortgages
Sub-primers would also stick to the same intermediary for sub-
     prime contracts typically entail very high initial pre-
     payment fees (exactly to discourage  intermediary!) 33
Sub-primes economics
Why sub-prime lending may disrupt markets
Credit markets plagued by information asymmetries
Borrower better informed of his probability of default than
    lender (adverse selection; AS)
Borrower may undertake actions – unknown to the lenders - to
    reduce probability of repayments (moral hazard; MH)
With either AS or MH prices (interest rates) can‟t be the only
    tool to clear credit markets
       AS: If lender raises interest rate, only the high-risk borrower
        would stay in the market while safe borrowers would leave
       MH: a party in contract would take excessive risk for it doesn‟t
        bear full consequences of his action
          Under limited liability, financial intermediaries would keep too many
           risky loans in their portfolio
          By same token borrowers may not act prudently with their received
           funds
                                                                            34
    Sub-primes economics
    Why sub-prime lending may disrupt markets

What do intermediaries do to protect themselves against
   informational disadvantage?
  Use other allocation tools in addition to interest rates,
   namely screening & credit rationing or collateral
       In sub-prime markets, loans against value of the house plus interest
        rate premium charged on prime borrowers
   Moreover: to reduce their exposure to insolvency risk, they
    can sell their mortgage-related credits in packages to other
    agents (“securitization”)
To sum up: informational asymmetries might put creditors at a
    disadvantage in standard competitive markets. Yet
    creditors have tools to react: screening, collateral and
    securitization

                                                                        35
 Sub-primes economics
 Why sub-primer defaults have been so disruptive
Lending against collateral, screening and securitization
    altogether raise the total amount of credit available to
    borrowers
Hence, in spite of informational asymmetries, benefits should
    accrue to households and firms as a result of the
    functioning of mortgage markets
This was not the case because other types of distortions added
    to informational asymmetries to worsen market outcomes
   Mis-priced collateral (bubble in housing markets)
   Scope for arbitrage in regulation and supervision in
    financial markets between different countries and
    institutions
Result: over-leveraging and excessive risk-taking for the world
    economy as a whole

                                                           36
 Sub-primes economics
 “Mortgage securitization”
Mortgage contracts are differentiated over time and between
     borrowers (house location, borrower‟s profile, lender‟s
     marketing strategy)
Yet financial markets may transform heterogeneous mortgage
     contracts in homogeneous products




                                                          37
 Sub-primes economics
 “Mortgage securitization”, more technical details
By issuing a mortgage to a borrower, a bank creates an asset
     that gives right to cash flows paid regularly over time
    Securitization occurs when these cash flows are sold to a
     Special Purpose Vehicle (SPV) administered by a financial
     institution
      Given that borrowers may default, value of this asset is risky for the
       SPV. Then SPV holds diversified portfolio of such assets, pooling
       together many borrowers with similar risks under some dimension,
       but not identical
      The SPV finances its purchase of cash flows by issuing securities
       (here is “securitization”!) called Mortgage Backed Securities
       (MBS), the biggest part of ABS (Asset-backed securities) in the US




                                                                         38
   The rise and fall of asset-backed securities throughout the 2000s



             Global
          issuance of
         asset-backed
         securities (a)




Source: Dealogic.

(a) Quarterly issuance. „Other‟ includes auto, credit card and student loan ABS.
(b) Commercial mortgage-backed securities (CMBS)                                   39
(c) Residential mortgage-backed securities (RMBS).
 Sub-primes economics – summing up
 From risky mortgages to “asset-backed securities”
How can this be? How can risky cash flow be turned into
     standardized “asset-backed securities”?
Trick: cash flow from well-diversified pool of mortgages is a
     cake that can be cut into slices (“tranches”) of increasing
     risk/return profiles in a Collateralized Debt Obligation
     (CDO)
Then: the cash from the pool of assets is used to pay interest &
     principal to the tranche with “senior” status; the remaining
     cash goes to pay the holders of the second tranche, with
     intermediate status; and so on.
By appropriately choosing the loss threshold from which the
     senior creditor is exempted, the SPV may generate at
     least one tranche of “AAA securities” that can be certified
     by a rating agency. Then there will be other tranches
     involving increasing risk and rated “AA mezzanine”, “BBB   40
     subordinated” and “first-loss position” (the “garbage”)
 Sub-primes economics – summing up
 From risky mortgages to “asset-backed securities”
Goal of the process: transform a bunch of heterogeneous risky
    mortgages into the largest possible pool of standardized,
    high-rating Asset-Backed Securities
Often certified by rating agencies (in conflict of interest for paid
    by the administrator of the SPV). Moreover, given that
    rating agencies set different criteria to award an AAA
    status, SPV would also shop around to find the rating
    agency with the easiest-to-satisfy criteria
On top of that, such securities have often been insured with
    insurance companies (Credit Default Swaps, CDS).
    Example: AIG, American Insurance Group, bailed out one
    day after Lehman has gone under
Finally, liquidity was an essential ingredient of the overall
    process: the ABS was usually of a shorter maturity than
    the underlying mortgages. Hence they had to be rolled 41
    over issuing new securities
   Here is why market liquidity literally vanished since August
   2007 (picture seen before)




Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill
Lynch, Thomson Datastream and Bank calculations.


(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity
measures, normalised on the period 1999–2004. The series shown is an exponentially weighted moving average. The indicator is more
reliable after 1997 as it is based on a greater number of underlying measures.                                                       42
 Sub-primes economics – Keywords
 From risky mortgages to “asset-backed securities”
Heterogeneous mortgages
Standardized Asset-Backed Securities (ABS) sliced in
    tranches with different risk/return profiles (CDO)
Certification by rating agencies
ABS insured with insurance companies (Credit
    Default Swaps, CDS)
Roll-over financing implied, liquidity crucial to the
    whole system



                                                     43
 The process described so far operated through a
 Parallel (or Shadow) Banking System
The parallel banking system is made of all the non-bank
  financial institutions (including investment banks) taking part
  in the process of credit creation for the rest of the economy.
  (Names? Bear Stearns, Lehman Brothers)
What did the parallel banking system do?
 Financed vast amount of real estate lending and consumer
  borrowing
 Made loans with no deposit base
 Used little operating capital and extremely high leverage
  ratios (=assets/capital). As a result, lots of profits
 Extended loans usually securitized and traded among
  financial firms



                                                             44
Where did such pressing credit needs come from?
Mario Draghi (Bank of Italy Governor)
“Credit has become something to be bought and sold in the
  market instead of being held onto the balance sheets of
  financial intermediaries”

Response to well known myth in the American society: the
  idea of the “ownership society”
   Founding myth of the US society

   revived by GW Bush




                                                           45
Greenspan’s endorsement of leveraged finance
Alan Greenspan (Fed governor before Ben Bernanke, from
   1987 to 2007) famously said in 2005
“The new instruments of risk diversification allowed bigger
   and more sophisticated banks … to get rid of the bulk of
   credit risk by shifting it to less exposed institutions.
These increasingly complex financial tools have
   contributed to the development of a more flexible and
   efficient financial sector, hence less exposed to shocks
   than the one that existed only twenty five years ago.
After the bubble bursting of the stock market in 2000, no
   major insolvency of any big financial institution, at odds
   with what happened in the past in the wake of big
   financial shocks”
                                               (italics are mine)
Yes, the Maestro said: “LESS EXPOSED INSTITUTIONS”
   and “LESS EXPOSED TO SHOCKS”
                                                                    46
Was Alan Greenspan crazy? Or may be simply
captured by investment banks?
No. Simply, “modern” (leveraged) finance has its pros
Expansion of financial markets  financial development 
  economic growth
Thanks to pooling and distribution of diverse risks

How?
Investor portfolios more diversified through creation of new
   financial products entailing different risk-return
   combinations
Reduction of ratio between required bank capital and
   originated credits
 More loans for given capital, more credit, more profits
 As long as things square well ..



                                                               47
The wrong side of the parallel banking system
A fragile business model
Natural mismatch of maturities – implicit in the functioning of
   modern credit systems - stretched to an extreme
 Loans are long term but their funding is short-term. Both
   with banks and parallel banking system
 Non-banking institutions particularly vulnerable to
   disruptions of money market funding, for their business
   model based on really short-term roll-over of funds
Moreover, securitization converted loans into financial
   instruments to be priced according to market conditions
 OK, as long as home prices kept rising

 When home prices fell, firms had to take large “mark-to-
   market” losses
 Given low capital ratios, losses quickly wiped out firms‟
   thin capital bases, thereby leading to a freeze of roll-over
                                                              48
   funding
Why the incentive system in place was distorted
Banks
   interested in cashing hefty fees for structured
    sophisticated financial products
   Less interested in monitoring the quality of credit (risks
    distributed to outside takers) or borrowers‟ behavior
Brokers
   Paid according to quantity of procured credit; in search of
    the mortgage taker with no evaluation of creditworthiness
Rating agencies
   supplied consulting on how to structure financial products
    whose quality they were supposed to evaluate
   Rating based on “optimistic” statistical models
      Two reasons for optimism: (a) rating based on recent (typically:
       two) “good” years and (b) no regard given to liquidity risk of
       “unusual” financial products


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Why the incentive system in place was
  distorted
Fund managers and desk traders
   fee structure based on principle Heads I win, tails you
    lose contributed to take excessive risk taking
   Being a senior executive at an investment bank, even
    if you knew you were in a bubble that was going to
    collapse, it was still in your interests to play along
   For at least two reasons
      the enormity of the short-term compensation to be made
       outweighed the financial risk of being fired in a bust (given
       severance packages, and the fact that in a downturn all CEO
       compensation would plummet)
      bucking the trend entails “CV risk” in such a way that
       playing along doesn‟t
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